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The Tenuous Tradeoff Between Risk and Incentives

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Canice Prendergast
Abstract

Empirical work testing for a negative tradeoff between risk and incentives, a cornerstone of agency theory, has not had much success. Indeed, the data seem to suggest a positive relationship between measures of uncertainty and incentives, rather than the posited negative tradeoff. I argue that the existing literature fails to account for an important effect of uncertainty on incentives through the allocation of responsibility to employees. When workers operate in certain settings, the activities that they should engage in are well known, and firms are content to assign tasks to workers and monitor their inputs. By contrast, when the situation is more uncertain, firms know less about how workers should be spending their time. As a result, the delegate responsibility to workers but, to constraint heir discretion, base compensation on observed output. Hence, uncertainty and output-based pay are positively related. I argue that parts of the existing empirical literature are better explained through this lens than with the standard model.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7815.

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Date of creation: Jul 2000
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Handle: RePEc:nbr:nberwo:7815

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J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs

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  1. Stefanie Aniela Lehmann, 2008. "When Randomization in Collective Tournaments is Profitable for the Principal," Bonn Econ Discussion Papers bgse19_2008, University of Bonn, Germany, revised Mar 2009. [Downloadable!]
  2. Keld Laursen, 2002. "The Importance of Sectoral Differences in the Application of Complementary HRM Practices for Innovation Performance," International Journal of the Economics of Business, Taylor and Francis Journals, vol. 9(1), pages 139-156, February. [Downloadable!] (restricted)
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  3. Dean Yang, 2004. "Can Enforcement Backfire? Crime Displacement in the Context of Customs Reform in the Philippines," Working Papers 520, Research Seminar in International Economics, University of Michigan. [Downloadable!]
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  4. Vicky Henderson, 2002. "Stock Based Compensation: Firm-specific risk, Efficiency and Incentives," OFRC Working Papers Series 2002fe01, Oxford Financial Research Centre. [Downloadable!]
  5. Francine Lafontaine & Scott E. Masten, 2002. "Contracting in the Absence of Specific Investments and Moral Hazard: Understanding Carrier-Driver Relations in U.S. Trucking," NBER Working Papers 8859, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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